Monday, May 18, 2009

Moody's is swinging the axe again, and in a move which could spell trouble for the rating for the US itself, it downgraded Japan's last triple-A foreign currency credit rating. Amusingly, Japan has almost no foreign currency debt exposure, so the action may be perceived as posturing by Moody's as it prepares for some sort of credit action on the US. In Moody's own words:

"We know there are challenges in Japan. That's why we don't think Japan is an Aaa," said Thomas Byrne, senior vice president for Moody's in Singapore.

"We think that the two-notch differential between the triple-As such as the U.S., France and Germany are warranted," he told a news conference in Tokyo.

The following is the language from the rating action itself providing justification for the rating event:

Japan's credit profile is Aa2

The unified rating of Aa2 reflects Japan's considerable strengths. These include Japan's large domestic savings, a strong home bias on the part of its domestic financial institutions and institutional investors, relatively low holdings of government debt by foreign investors, and Japan's $1 trillion of official foreign exchange holdings. Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus program.

However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates. The ratings also reflect the sizable but temporary increase in the government's budget deficit caused by the severe effects of the global collapse in trade and recession on the Japan's economy. Further, Japan's large foreign exchange reserves, although large compared to those of most other countries, are only a small fraction of its liabilities and could not alone eliminate refinancing risk at a time of severe stress.

For the government's bond rating to move higher, Japan's economy would need a sustained recovery and the government would need to shrink its budget deficit and lower its debt trajectory. Conversely, the bond rating would be under pressure if the trend in debt increases continues, which could result from demographic pressures on social welfare and pension expenditures, or if the market loses enthusiasm for the government's new debt issuances.

It is no secret that at the current inflection point, the threat of skyrocketing debt and "lack of appetite" for new debt issuance is much more severe at other sovereigns (hint: the US) is much higher than that of Japan. Thus, based just on this information, one should expect some adverse credit language focusing on either the U.K. or the U.S. relatively soon.

"The move to lower Japan's foreign currency bond rating from Aaa opens the way for speculation about whether Moody's will take similar actions on other triple-A ratings," said Kenro Kawano, senior rates strategist at Credit Suisse in Tokyo.

"Also, with Moody's citing as Japan's strengths its funding ability, it also fuels speculation about a cut to a triple-A rating on a country which cannot fund itself."

With US CDS having been hit by a massive short covering wave, and recently trading in the 30s, a downgrade would potentially have a catalytic event on this manifestation of risk, and as such the upside/downside of the US CDS, which had traded at 100 as recently as 2 months ago, may be a prudent analysis.

Moody's is swinging the axe again, and in a move which could spell trouble for the rating for the US itself, it downgraded Japan's last triple-A foreign currency credit rating. Amusingly, Japan has almost no foreign currency debt exposure, so the action may be perceived as posturing by Moody's as it prepares for some sort of credit action on the US. In Moody's own words:

"We know there are challenges in Japan. That's why we don't think Japan is an Aaa," said Thomas Byrne, senior vice president for Moody's in Singapore.

"We think that the two-notch differential between the triple-As such as the U.S., France and Germany are warranted," he told a news conference in Tokyo.

The following is the language from the rating action itself providing justification for the rating event:

Japan's credit profile is Aa2

The unified rating of Aa2 reflects Japan's considerable strengths. These include Japan's large domestic savings, a strong home bias on the part of its domestic financial institutions and institutional investors, relatively low holdings of government debt by foreign investors, and Japan's $1 trillion of official foreign exchange holdings. Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus program.

However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates. The ratings also reflect the sizable but temporary increase in the government's budget deficit caused by the severe effects of the global collapse in trade and recession on the Japan's economy. Further, Japan's large foreign exchange reserves, although large compared to those of most other countries, are only a small fraction of its liabilities and could not alone eliminate refinancing risk at a time of severe stress.

For the government's bond rating to move higher, Japan's economy would need a sustained recovery and the government would need to shrink its budget deficit and lower its debt trajectory. Conversely, the bond rating would be under pressure if the trend in debt increases continues, which could result from demographic pressures on social welfare and pension expenditures, or if the market loses enthusiasm for the government's new debt issuances.

It is no secret that at the current inflection point, the threat of skyrocketing debt and "lack of appetite" for new debt issuance is much more severe at other sovereigns (hint: the US) is much higher than that of Japan. Thus, based just on this information, one should expect some adverse credit language focusing on either the U.K. or the U.S. relatively soon.

"The move to lower Japan's foreign currency bond rating from Aaa opens the way for speculation about whether Moody's will take similar actions on other triple-A ratings," said Kenro Kawano, senior rates strategist at Credit Suisse in Tokyo.

"Also, with Moody's citing as Japan's strengths its funding ability, it also fuels speculation about a cut to a triple-A rating on a country which cannot fund itself."

With US CDS having been hit by a massive short covering wave, and recently trading in the 30s, a downgrade would potentially have a catalytic event on this manifestation of risk, and as such the upside/downside of the US CDS, which had traded at 100 as recently as 2 months ago, may be a prudent analysis.